Inflation: the road back to 2%

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Good morning. Kia ora koutou katoa. Thanks for joining us on this live webinar coming at you from at Te Pūtea Matua, the Reserve Bank in Wellington. So yeah, welcome, great to, thanks for clicking in. We're sort of looking forward to it. So the speech that I'm about to deliver is being published on our website currently at the moment. It should be there now hopefully. And you can actually, there's quite a few figures in this speech. It's sort of a bit of a presentation as well. So you can follow along in the speech on the website or there'll be flicking across the screen as well. I'm going give the speech slash presentation that'll take, I dunno, 25 minutes or so depending on how much ad-libbing I do. And then we are going to have a Q and A session for a bit. So there'll be a chat box on your screen so as we're going through, just put questions in there and then we will get to as many of those as we can after the speech.

Now there are two reasons why we're doing this. First of all, when I was lucky enough to get this job a couple of years ago, I said that we are going to talk more. So this is us talking more. The other thing is that we are publishing a heap of research alongside this speech and the speech effectively pulls together a lot of that research into a narrative. So we using research to, we're pulling research into the policy space, into the monetary policy space, which of course makes that research very useful and it strengthens where we're at from a monetary policy perspective. Alright, so let's get going. So yeah, as I said, thank you for tuning in. Great to have you with US inflation. It's been at the forefront of national and global discussions and concerns since partway through the COVID-19 pandemic. So coming out of the worst of the pandemic inflation in New Zealand and in most other countries was or reached rates that have not been seen or had not been seen since the inflation targeting era began more than a generation ago.

So annual consumer price index inflation, that's CPI inflation in New Zealand, it has moderated significantly over the past year or so. So we are making good progress but it remains above both pre pandemic levels and also the monetary policy committee, the MPCs one to 3% target range. So looking ahead we face some remaining challenges and uncertainties in bringing inflation sustainably back to target. So today I'm going to talk about why inflation dynamics changed in the New Zealand economy during the pandemic and what the road back to 2% inflation looks like from here. This is going to include a discussion on some of the risks and uncertainties that the MPC needs to balance as we navigate back to 2% inflation. Now just upfront the key insights for monetary policy from a monetary policy perspective, I've got two of them. First of all, there are some reasons to think that inflation may be more persistent than in our current projections in the near term.

So in other words, more sticky down to the downside and most notably domestic or non tradables inflation. And we're going to be talking about that a lot and services sector inflation have held up more than initially projected. However, there are also some reasons to think that inflation could fall more quickly than expected over the medium term. So for example, increasing spare capacity in the economy and product and labour markets could translate into lower inflation more quickly than currently expected. Also, business and household inflation expectations could hasten the decline as actual inflation falls continues to fall. So currently our policy strategy is balancing these opposing factors and as we noted in the May Monetary Policy Statement, monetary policy needs to remain restrictive to ensure that inflation returns to target within a reasonable timeframe and stays there notwithstanding future shocks, et cetera, et cetera. As always, we will be watching indicators of core inflation, non tradables inflation services, inflation and inflation expectations to get a read on how the balance of these factors is playing out going forward.

And of course the labour market is also providing really important signals on capacity pressures in the economy. So in this speech we are going to delve into recent reserve bank research and analysis on these factors. But first I want to set up that discussion by outlining several different components of inflation and how they matter from the perspective of our medium term flexible inflation targeting framework. And then I'll talk about inflation dynamics and their drivers over recent years and then we'll finish up with a discussion on what it all means for monetary policy overcoming quarters as we continue to bring inflation back to target. Alright, so first some words on medium term inflation. So MPC our remit requires us to keep annual headline or overall consumer price index CPI inflation between one and 3% with a focus on the 2% target midpoint and we're to do that over the medium term and we're also to do that while seeking to avoid instability in the economy.

Now to achieve this NPC sets monetary policy usually via the official cash rate or the OCR such that inflation is expected to return to target over the medium term and in most instances NPC we aim to return inflation to target to the midpoint of the target within a one to three year horizon. That's the medium term. Now this approach recognises that changes in the official cash rate take time to transmit, to percolate through the economy and influence inflation and also by ignoring or as we say looking through short-term price changes. This approach also ensures that the monetary policy committee does not cause unnecessary economic volatility by changing interest rates in response to inflation blips that would fade naturally in time in any case. So it follows that a really key consideration in setting the OCR is whether inflation pressures today are likely to linger into the medium term future.

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Core inflation gives a steer on persistent inflation. Graph showing headline and core inflation from 2008 to 2023.

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Now one of the ways in which we assess this is by using various measures of core inflation and you can see one of those measures on figure one here. So the sort of pink or raspberry or maro line there is one of our measures of core inflation, whereas the blue line is headline inflation. So you can see in the early days of the pandemic, oops, that headline inflation increased much more quickly than core inflation and I'll talk about that in a minute and you can see also that core inflation is now falling below headline inflation and I'll talk about that later on in this speech. So these measures, they help us identify persistent inflation pressures in the economy essentially by stripping out volatile price movements from the CPI. Now there's another useful gauge of medium term inflation pressures and that is non tradables inflation. So non tradable goods and services they tend not to be traded as it says on the tin not to be traded in global markets or exposed to global competition.

And they're really important. They make up about 60% of New Zealand CPI basket. Now non tradables inflation it tends to reflect capacity pressures and price and wage setting behaviours in the domestic economy very much linked to domestic economic conditions. In contrast, tradables tradable goods and services, they are traded internationally and tradables inflation as a result largely reflects changes in international prices that are driven by global developments and of course movements in the exchange rate.

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Core non-tradables inflation broadly move together. Graph showing inflation subgroups versus core inflation.

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Now in practise our two measures of medium term inflation core and non tradable inflation, they broadly move together and you can see that in this chart here. So the sort of purple and raspberry lines, they're not on top of each other but they broadly move together. Whereas tradables inflation, that's the blue line there, it's more idiosyncratic and it's more volatile quarter on quarter. So the factors that are influencing tradables inflation such as the exchange rate and global commodity prices, especially for oil or petrol, they're relatively volatile, they bounce around quarter on quarter whereas the factors influencing non tradables inflation such as wage dynamics in the domestic, the New Zealand labour market, they're less volatile and they can be relatively sticky.

Now of course core inflation includes prices for some tradable goods and services, but any short term volatility in those prices is largely stripped out in the measurement of core. So it follows that core and non tradables inflation are measures of medium term inflation pressures in the economy and therefore they're absolutely key in the conduct of monetary policy. Alright, with that sort of as background, let's turn to the inflation surge over the last few years. What's the big picture around that? So looking at recent history inflation in ERO in New Zealand, it breached the upper 3% limit of our annual CPI inflation target in the second quarter of 2021. And from there it rose to a peak of 7.3% a year later, second quarter of 2022. Now initially this inflation surge was driven by rapid increases in tradables inflation and again you can see this in the graph here.

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Tradables inflation down, non-tradables persists. Graph showing inflation subgroups versus core inflation. Annual deviation from average since 2000.

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So the blue bars are non tradables, the raspberry bars are tradable. So you can see tradables inflation really surged away in the early quarters of the pandemic. So much of this initial increase was driven by short-term factors, meaning that the increase in headline CPI inflation was not reflected in higher core inflation. I showed you that back on figure one. Headline inflation increase much more quickly than core inflation. Headline increased well above core inflation during the initial inflation surge. Now over late 2021 and into early 2022, inflation became more generalised and more persistent as cost pressures spread throughout the economy and workers and businesses started to expect higher inflation in future.

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Non-tradables inflation has broadened. Graph showing contributions to non-tradables inflation by category.

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So as a result both core inflation and non tradables inflation increased over this time. Now much of this initial increase in non tradables inflation was due to price increases for housing related services. So again, you can see that on this graph the green bars there are increases in inflation for housing related services.

You can see that was sort of the first to get out of the box. So why did that happen? Well most of us were spending more time at home because of the pandemic interest rates were low and fiscal policy was expansionary. So as a result, demand for housing related services increased but we didn't have an equivalent increase in the supply of workers, we didn't have an increase in construction materials, the supply of construction materials. So in that context increased demand translated into strong price increases for these housing related products. Now from the September quarter into 2023, housing related inflation began to fall partly because of increasingly restrictive interest rates. But as I mentioned earlier, excess demand and rising costs became a wider theme in the economy and high inflation broadened into prices for other non tradable items. And this included things like market services, restaurant meals, ready to eat, food administered goods and services such as alcohol and tobacco because of excise or partly because of excise tax and council rates, the kind of stubborn bits of inflation that we've been talking a bit over recent quarters.

Now more recently non tradables inflation, it has persisted and I'm going to say more on that in a minute. But those volatile short-term price pressures have faded and tradables inflation has quickly declined. So as a result, headline inflation has now or is in the process of falling below core inflation as we saw on that earlier chart. Alright, so let's dig a little bit deeper into this inflation surge. So to better understand the inflation surge reserve bank researchers have been exploring some of the deeper potential causes to these inflation dynamics. And let's start with reserve bank work looking into the role of supply and demand and influencing inflation pressures in the economy. So a study being released alongside the speech finds that retail prices, they actually fell at the start of the pandemic with demand slowing as people went into the first lockdown. And you can see that in this figure here that sort of the red bars are demand shocks and the blue bars are supply shocks.

So demand sort of fell in the early days but then that demand shock, it turned positive and it put significant upward pressure on retail price inflation from mid 2021.

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Supply shocks a more important influence recently. Decomposition of headline retail trade deflator.

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Now this increase in demand partly reflected covid era fiscal and monetary policy stimulus. So the effects of monetary policy over this period, we've been researching that obviously and they have been canvassed in a recent review which you can see on our website. I will say that I think people will be studying this period for decades if not generations to come economists that is. And I will also say that there has been less analysis of the full range of macroeconomic effects from fiscal policy over the pandemic. I think however it's important to say that the size of New Zealand's discretionary fiscal response, it was at the upper end across OECD economies. Now from 2022 the impact of demand shocks in driving retail prices began to wane as you saw on that earlier graph.

However, as some pandemic health related restrictions started to ease from late 2021, the composition of aggregate demand swung from goods, things that could be delivered while we were in lockdown to services, things we hadn't done for a while, like going out for dinner or going on a little holiday. And this occurred in the context of widespread disruptions and shortages on the supply side of the economy. So supply shocks became much more important in influencing inflation as we got through the pandemic. Alright, so that's one sort of approach to decomposing what happened over that time. Looking through a different lens gives us a similar story. So another study, another analytical note being published with the speech. It assesses some of the direct and indirect factors influencing wage and price inflation over recent years. And this work it suggests or it tells us that the labour market played a key role in New Zealand's inflation experience over the pandemic and actually a bigger role than seen in other countries to the extent that we've got comparable data for other countries.

So as aggregate demand began increasing from sort of mid 2021, labour demand started to increase. Make sense? We call that EM'S law but at the same time the border was closed so immigration inflows were at a virtual standstill which severely constricted labour supply in our economy. Now this tightening in labour market capacity pressures according to this research was the most important factor driving up wages over the pandemic and you can see that in this chart here, which decomposes wage inflation over the pandemic. The green line there is the contribution of a tight labour market and you see it was pretty powerful in the early days of the pandemic.

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Labour market tightness key to wage inflation. Decomposing annual LCI wage inflation during the pandemic era.

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Later on labour market the border opened and labour market pressures began to ease contributing to much less wage inflation and also tighter monetary policy by this point was also helping to limit inflation. Now in the product market this work suggests that the largest contribution to CPI inflation over the pandemic came from labour market tightness and supply shortages.

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Labour market tightness, supply shortages key to CPI inflation. Decomposing annual CPI inflation during the pandemic era.

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So you can see that in this graph the green and the sort of brown bars show you the contribution of tightness in the labour market and supply shortages to inflation over this period. And again, that large contribution from the tightness in the labour market likely reflects the ongoing impact of the closed border on labour supply and the persistent effects of global and domestic supply chain disruptions in combination with robust demand in the economy at the time. You can also see from the graph that increasing food prices have also been relatively persistent. That's the kind of purple line there and that is partly reflecting the impact of cyclone Gabrielle. But in contrast, the impact of energy prices on inflation in New Zealand has been relatively mild. So we weren't anywhere near as affected by the spike in global energy prices from the aggression in Ukraine that was relatively small here, just given that we were so far away from that shock as opposed to economies in Europe and the UK where energy price inflation played a huge role.

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Labour market tightness a larger factor here. Factors influencing inflation across countries over the pandemic era. Factors include, energy prices, food prices, labour makrket tightness, supply shortages, productivity.

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Now compared to other countries, to the extent we've got comparable data, labour market tightness bought about by the closed border and strong domestic demand had a big impact on inflation in New Zealand, which is not surprising. So migration plays a large role in growing the labour force here compared to other countries and also structurally the New Zealand economy, we are more labour intensive or capital shallow compared to many other countries and that would've also amplified the inflationary effects of that border being closed. Alright, so we are to from here now as we discussed in detail in our main monetary policy statement, we expect that domestic or the non tradables contribution to annual headline CPI inflation will continue gradually easing over coming quarters and this is going to set the stage for headline inflation to return to within the target by the end of the year. Alright, there are two sort of important contributions to this decline, sorry, there are two important contributions to this expected slowdown in non tradables inflation.

First of all, we expect spare capacity to start emerging in the economy over 2024. And this is after several years of the economy growing well beyond its sustainable rate. So demand has been greater than supply over the last few years. We're now entering a period where demand is beneath the potential growth beneath supply in the New Zealand economy. So capacity pressures are easing capacity, spare capacity is opening up in the economy and we expect the spare capacity to feed through strongly into lower domestically generated non tradables inflation. Now of course this expectation is supported by heaps of research including one of the papers or one of the notes we put out with this speech.

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Effect of capacity pressure on inflation stronger than pre-COVID. Relationship between inflation and capacity pressure.

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So another study being published with the speech finds that the effect of capacity pressures on inflation and for the economists out there, this is what we call the Phillips curve, we find that relationship between capacity pressures and inflation has become stronger over recent years.

And you can see this in figure nine here. So this kind of purple raspberry line is the link between capacity pressures and inflation and you can see it has clearly increased over the pandemic. So capacity pressures are having a bigger impact on inflation now than they were prior to the pandemic. So this strengthening in the Phillips curve relationship, it indicates that excess demand for goods and services and for workers in the labour market from partway through the pandemic was strongly reflected in higher inflation as we saw earlier. But it also suggests that remaining inflation could decrease quickly as spare capacity emerges in product and labour markets over 2024 I will say there's been a bit of talk of stagflation, I've seen a few headlines to that extent over the last couple of weeks. New Zealand we're not in a stagflationary environment like yes we are in a slow to no to negative growth environment but that the outlook for growth is slightly more positive going forward and the outlook for inflation is for declines to continue.

So that's the Phillips curve doing its thing, it's as anticipated and as required to get inflation back down to 2%. It is not stagflation. Now the second reason why we're confident about inflation falling is because we expect households and firms to increasingly build lower inflation expectations into their wage and price setting decisions, inflation expectations, they can become self-fulfilling. So lower inflation expectations will help reduce inflation. Persistence in the economy, and again we've done some research in this and it finds that above target in inflation over recent years, it prompted people to pay more attention to recent inflation and to update their inflation expectations more frequently. Inflation's been everywhere in the news obviously in the supermarket, so we're very focused on it and as high inflation expectations become more widespread, workers are more likely to bargain hard for wage increases. It's also really important to note that high actual and expected inflation, it also makes it easier for businesses to increase their prices.

So Reserve Bank research finds that businesses in New Zealand are more likely to increase their prices by more and more frequently when inflation is high. So when's the best time for a business to put up its prices when everybody else is putting up its prices? So these behaviours reinforced upward momentum in headline CPI inflation over recent years. But the opposite could occur as headline inflation continues to fall and recent falls in inflation expectations are very welcome in this regard and will help to embed lower inflation persistence going forward, moving from a period of high inflation back to a period of low inflation. So it's becoming increasingly difficult for businesses to increase prices in that new lower inflationary environment. Visual: Drops in inflation expectations will help embed lower inflation persistence. Graph showing inflation expectations and headline CPI.

Price increases are being noticed by consumers and of course if a business thinks inflation is going to be high in future, the temptation there is to sort of increase your price by a little bit more to try and get ahead of the curve.

But those days are, well they're almost behind us. Alright, so how is this going to play out in the inflation data? As I mentioned at the start, non tradables and core inflation will give us a steer on how quickly medium term inflation pressures are moderating in the economy to date declines in non tradables inflation. They have been concentrated in products that are sensitive to changes in monetary policy and again, we've done some work on this, we've split non tradables into three categories that respond quickly or medium term response or a slower response to monetary policy. And you can see that on the graph here. So the raspberry line there is faster responding products. You can see that that category of non tradables inflation for those products increased quickly at the onset of the pandemic but also what went up quick has come down quickly.

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Non tradables inflation down via monetary policy sensitive prices to date. Graph showing non tradables inflation and monetary policy sensitivity.

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So inflation in that category is now almost back at pre pandemic levels, which is great, but we anticipate that disinflation is going to spread across a wider set of nont tradables that typically take longer to react to monetary policy.

And this is things like restaurant meals, ready to eat food, et cetera, et cetera. And again, you can see from the chart this is the medium response there. Its products in that category of non tradables inflation in this category of non tradables increased relatively slowly over the pandemic and has only recently started to decline and this decline is likely to continue particularly as conditions in the labour market continue to ease. So many of the products in this category are labour intensive and therefore particularly sensitive to what's going on to pressures in the labour market. Now importantly there are some non tradables that respond only slowly if at all to changes in monetary policy. And again, you can see that in the graph that's the purple line there. For example, inflation in some administered goods prices is going to fall with a delay. Excise tax for example is indexed to CPI.

So high inflation sort of gets baked in to prices for products that are subject to that tax prices for other non tradables in this category such as insurance have been slow to respond or they haven't responded to restrictive interest rates and the pace of increases in prices for these products may only start to wane after other factors that are driving them upwards such as pandemic and weather related disruptions have fully run their course. Monetary policy is having a small to zero influence on prices for those products compared to those other forces driving them in the economy. But those other factors will run their course. There's no such thing as a price that just keeps going up forever and ever. So overall we expect to see slowing inflation spread out across a greater share of non tradable products and the extent of large price increases across the CPI to return to its pre covid average.

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Slowing inflation needs to become more broad-based. Graph showing distribution of CPI price changes.

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So you can see from this graph here that 40% of items in the CPI basket, this is in the first quarter of 2024, 40% of those items went up by more than 5% in the first three months of this year. Over 70% of items in the CPI basket went up by more than 3% in the first quarter of this year. So we expect to see large price increases like that return to where it was pre covid. Pre covid it was under 10% for the share of CPI items going up more than 5%. Alright, so in conclusion, inflation spiked higher during the pandemic due to a range of factors with a shortage of labour and materials in a period of strong demand being particularly important, broad-based non tradables inflation has been key to driving medium term inflation pressures. Now good progress is being made in bringing inflation back to target, but increasing spare capacity in the economy is likely to further reduce inflation pressures going forward and a further easing in the labour market will be a key part of this process.

Lower inflation expectations and a lower propensity for firms to make relatively large price increases will also help lower inflation persistence going forward. And these processes, they could occur more quickly and more slowly than we are currently projecting. The risk of ongoing strength and non tradables inflation is balanced by the potential for a quicker moderation in inflation expectations and increasing spare capacity in the economy passes through to weaker demand and weaker prices overall, a period of restrictive policy is necessary to give us confidence that inflation will sustainably return to target over a reasonable timeframe. Thank you for that. That's it as far as the set piece go, we're going to shift to Q and A. So we've got James here who's been moderating questions, hopefully questions that have been coming in and is going to throw some at me now.